I should probably be studying, but this didn't take me that long to work out and was pretty interesting.
This could be considered another extension of the tactical asset allocation system developed by Mebane Faber that I have blogged about several times. The original strategy is to invest in five asset classes (US bonds, US stocks, Foreign stocks, Commodities, Real Estate) when they are greater than their 200 day moving average and commercial paper otherwise.
I modified the system slightly, maintaining the 200 day moving average requirement, but I added an additional constraint: it could not be the case that it was above the 5 month (4 and 6 have similar results) moving average and the return over the previous month was negative. The point of this was to take into account periods being overbought and then getting back in quickly. The periods above the five month that have negative prior month returns have very poor risk to reward ratios, most significantly for stocks and REITs. So making this simple addition can take a system with an 11.9% historical return with 6.8% standard deviation (.867 Sharpe at 6%) to 11.8% with 5.68% standard deviation (1.026 Sharpe). Though there is not a statistically significant difference in means, there is a significant difference in standard deviations according to an F test.
Not only is this improvement a significant, easy to implement improvement, but it is based on logic. Most trends do not continue up continuously. There tend to be pull backs. This strategy maintains the idea that the trend is your friend and attempts to stay out of a pull back if it happens two months in a row.
Note: the portfolio leveraged 50% has a 14% return with 8.5% standard deviation compared to 13.5% with 9% standard deviation for the original version. The best benefit in reducing standard deviation is in keeping the risk to reward statistics strong when using leverage.
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2 comments:
At the cost of greatly increasing the number of trades.
I ran this with SPX (1972 to present, 436 months), and got 49 trades with the original 10 month SMA signal and 131 trades with this modification.
It had the effect of having you out in 32 months which had a gain, and 23 months which had a loss. This didn't look promising--you missed out on a lot of profitable months.
But then I looked at those 55 months. Most of them were only a few percent gain/loss. But some of the losses were doozies!
Mar90: 10%. Jan91: 5%. Oct98: 22%. Aug90: 10%. Aug98: 15%.
So I guess that this is indeed a valuable modification, since it helps you avoid a small number of infrequent huge losses.
You're right Ray. However, if you're using futures contracts you only face additional (minimal) trading costs. If you're just using ETFs, then you lose the tax advantages of holding long-term gains and that can have real effects on the portfolio. I probably should have mentioned that.
Also, since the benefits of the strategy comes from avoiding a few large losses, then it will not necessarily be successful in the future. Probably should have noted that in the post so thanks for pointing it out.
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